Dorrance v. U.S., 2015 WL 8241954 (9th Cir. 2015)
This case is the latest in the cases involving tax impact of the sale of stock received by a policy holder from a mutual life insurance company on demutualization, and a case of first impression at the Federal circuit court level. Here, the Dorrances purchased life insurance policies from several mutual life insurance companies in 1996 to replace the then estimate of their anticipated estate tax liability. In 2003, the Dorrances received stock in the resulting stock company when each of these mutual life insurance companies demutualized in a tax free transaction into a stock company. The Dorrances then sold this stock also in 2003, and reported the sales on their 2003 income tax return as capital gain transactions, reporting a zero cost basis. The Dorrances later filed a claim for refund, now asserting that the stock received in the demutualization had a cost basis calculated in large part on the premiums paid for the life insurance policies prior to demutualization. When the Service did not respond to the refund claim, the Dorrances filed suit seeking a refund.
In the refund suit, the Dorrances, as the taxpayers, had the burden of proving their cost basis in the stock sold in 2003. They argued that the cost basis was equal to the value of the stock at the time it was received, the time of the demutualization. The government took the position that the stock had zero basis. The district court in Arizona ruled that the stock had some calculable basis, less than the value at the time of demutualization, but greater than zero. Both the Dorrances and the government appealed and the 9th Circuit ruled that the Dorrances had the burden of proving their cost basis and they failed to establish that they had any basis in the membership rights for which they had received the stock distributed in the demutualization.
With a mutual life insurance company, the policyholders own the company. The premiums paid for the life insurance policies, to the extent these premiums exceed the policy expenses, are returned to the policyholders in the form of dividends. Dividends received in cash, used to buy policy riders, to pay premiums or to pay principal or interest on policy loans reduce the policy owner’s investment in the contract, and dividends used to purchase paid-up additional insurance neither increase nor reduce the investment in the contract, since they remain in the policy. Dividends are generally not taxable, unless and until the cumulative dividends, combined with all other non-taxable distributions from the policy, exceed “the aggregate of premiums or other consideration paid or deemed to have been paid by the recipient.” See Reg. Sec. 1.72-11(b)(1). Once the dividends exceed the policyholder’s investment in the life insurance contract, the dividends paid out in cash, or cash withdrawn from the policy as a result of a policy cash-in or partial or complete policy lapse, are taxed as ordinary income. The premiums are treated as payments for the life insurance contract and are not allocated in any part to the membership rights of the policyholders of a mutual life insurance company. There are no excess premiums that would be available to provide basis build up for membership rights of the policyholder of a policy purchased from a mutual life insurance company.
So held the 9th Circuit, that the premiums paid by the Dorrances were for the life insurance policy contract and that none of the premiums were paid for the membership rights. Since the Dorrances had zero basis in the membership rights that were demutualized, when they received stock in a tax free reorganization in which their membership rights were replaced with the stock of the stock life insurance company, they had zero basis in the stock received. As the court expert put it, the stock in the subsequent stock life insurance company was received by the Dorrances as a “windfall”. In fact, in the materials received by the Dorrances from the mutual life insurance companies with regard to the receipt of stock, each of the companies indicated that “the cost basis of these shares for tax purposes will be zero.” The Court agreed.
The government had attempted to suspend action in a similar case involving the same issue that arose in California pending the outcome of the Dorrance case. However, after the government lost its zero basis argument in Fisher v. U.S.,82 Fed. Cl. 780(2008), Timothy Reuben decided to file his Federal refund claim to recover the taxes paid on his sale of the Manulife shares distributed to him from the Don H. and Jeannette H. Reuben Children’s Irrevocable Trust that the Reuben Trust had received on the demutualization of Manulife. Reuben had reported the sale initially showing a zero basis, and later filed his claim for refund claiming that he had a calculated cost basis in these shares on the same basis as the Fisher court had determined.
The Fisher court determined that the “Open Transaction Doctrine” applied. Under that doctrine, where there are several parts to property for which it is “impossible or impractical” to apportion the cost basis among, the taxpayer does not recognize any capital gain on disposition of a part of the property until the entire cost basis of the property has been recovered. The Fisher court determined that the premium paid by Fisher were for the acquisition of both the insurance policy and the ownership rights in Manulife, a mutual life insurance company. When the company demutualized, Fisher elected to receive cash in lieu of stock, which cash reduced his investment in the contract, his basis in the life insurance policy, under the Open Transaction Doctrine. On this ground, the Fisher court ruled that Fisher was entitled to his refund.
In Reuben v. U.S., 2013 WL _____________, the U.S. District Court in the Central District of California issued its opinion on January 15, 2013, denying Reuben’s motion for summary judgment based on the argument that the Open Transaction Doctrine applied in Fisher should be applied here. First noting that the Fisher opinion had been criticized, the Reuben court then noted that Fisher had elected to receive cash, and Reuben had elected to receive share of the stock company, on the demutualization of Manulife, a distinction the court found compelling in its refusal to follow the Fisher decision. The Reuben court then granted the government’s motion for summary judgment, stating that Reuben had the burden of proving his basis in the stock sold, and that Reuben provided no evidence in support of his position that some portion of the premiums were paid for membership interests. The court found that government “adverted to substantial evidence” that no portion of the premiums were paid for the membership interests in Manulife, that is (i) at the time of demutualization, Manulife informed its policyholders that the tax basis in the shares received would be zero, (ii) the actuary hired by Manulife at the time of the demutualization viewed the stock as a windfall to the policyholders, (iii) the actuary hired by the government agreed that the stock had no basis and that the process of demutualization is what gave the shares value, and (iv) the premiums paid for the Manulife policies after the demutualization was the same as before the demutualization, for the life insurance policy and not for the membership rights.
It would seem that Reuben’s rush to court was simply a rush to incur more legal fees that could have been avoided if he had just agreed to suspend the case until the 9th Circuit had issued its opinion in Dorrance.
(This is an updated post from December 2014)
Need a New Year’s resolutions to kick start 2016? Here is an idea you probably hadn’t considered: review your estate planning documents.
If you are like most people, you are probably thinking that reading legal documents does not sound like an even remotely enjoyable way to start a new year. But, it doesn’t have to be as unpleasant as it sounds. Reviewing your documents does not mean you have to read them cover to cover. If you know what are the most important elements, it is easy to review your will, trust, and powers of attorney regularly to ensure they still comply with your wishes. These documents not only determine who will receive your property when you die, but also likely determine who has the right to make financial and major medical decisions during your lifetime. Needless to say, it is important that you are still comfortable with the designations you have made.
To get you started, below is a basic checklist of items we suggest you review annually (make it a New Year’s tradition!).
1. Assess the changes in your life since you last updated your estate planning documents.
Have you gotten married or divorced? Had a child or adopted a child? Moved to a different state? Had a death in the family? Had a major financial event? Any of these life changes may affect your estate planning, and your documents may need to be revised. (more…)
The trailers for the newest installment in the Mission: Impossible franchise, Mission: Impossible Rogue Nation, are being released and, as always when we see actors performing daredevil stunts, it makes us think about life insurance. Hazard (I use the term loosely, in light of what these guys do) of the job, I guess. So, once again, we thought we’d remind everyone about the use of life insurance trusts to reduce estate tax by re-posting the blog we wrote in after seeing his stunts for Ghost Protocol.
And, for your viewing pleasure, share another video of Mr. Cruise’s stunts. (I’m starting to think Tom Cruise or Mission: Impossible should start sponsoring our blog!)
It’s true, it is possible to transfer life insurance proceeds to your beneficiaries without having to pay estate tax on those proceeds. An insured can create an irrevocable trust that is designed to be the owner and beneficiary of a life insurance policy on the insured’s life. The only amount that the insured would end up paying transfer tax on (or allocating unified credit to) would be the amount the insured transfers to the insurance trust to pay the premiums on the policy. If the amount contributed to the trust does not exceed the annual exclusion amount allowable to each of the beneficiaries of the trust, and if the trust is designed to give the beneficiaries crummey withdrawal rights (the right to withdraw any such contributions to the trust over the period of 30-45 days after the transfer), the insured/grantor would not have to use any of his or her unified credit or pay any gift tax on these transfers, either. (more…)
Several non-community property states have recently enacted statutes authorizing the creation of a joint trust by spouses that would be treated as entireties property, protected from the creditors of either spouse during their joint lifetimes, but would split into a separate Family Trust and Survivor’s Trust when one of them died. The question many estate planning lawyers have raised is whether the Family Trust would be includible in the survivor’s estate for Federal estate tax purposes when the survivor died. This question has now been answered at least as to one taxpayer in a private letter ruling, PLR 201429009 (released 7/18/2014).
In this private letter ruling, a Husband and Wife created a joint revocable trust. During their lives, they contributed their joint property to the trust and the trust provided that each of them held an undivided one-half beneficial interest in the trust as tenants in common and not as joint tenants.
On the death of Wife, the trustee was to divide the joint trust into a Family Trust with Wife’s trust assets and a Survivor’s Trust with Husband’s trust assets. Husband could amend and revoke the Survivor’s Trust, and on the death of Husband, he had a general power of appointment over the Survivor’s Trust. (more…)
U.S. News and Best Lawyers have joined to rank more than 12,000 firms in the U.S. in 120 practice areas in 174 metropolitan areas and 8 states.
Bryan Cave’s Trust and Estates Practice Group (“Private Client CSG”) received National First Tier Ranking and the Atlanta, Kansas City, Orange County, and St. Louis offices all received First Tier Rankings in metropolitan cities.
Congratulations to the Private Client Group!
The 2015 report of more than 12,000 firms by practice area is based on a rigorous evaluation process that includes the collection of client and lawyer evaluations, peer review from leading attorneys in their field and review of additional information provided by law firms as part of the formal submission process. Results were combined into an overall “Best Law Firms” score for each firm.
In two substantially identical private letter rulings, PLR 201423009 (released 6/6/2014) and PLR 201426005 (released 6/27/2014), the taxpayers requested guidance as to the impact of a sale of a survivor life policy from a grantor trust where both insureds are the grantors to a grantor trust where only one of the insureds is the grantor.
The proceeds of a life insurance policy are free from income taxation in the hands of the recipient after the death of the insured(s), unless during the life of the insured(s) there was a transfer of an interest in the policy for valuable consideration. However, the transfer for value rule does not apply in two circumstances set out in § 101(a)(2)(A) and (B).
1. As provided in § 101(a)(2)(A), the transfer for value rule will not apply where the basis in the policy for purposes of determining gain or loss in the hands of the transferee is the same as the basis in the policy for purposes of determining gain or loss in the hands of the transferor. (more…)
Frequently, taxpayers are surprised by the fact that the ownership or receipt of a life insurance policy can result in taxable income, as was the case in Gluckman v. Commissioner.
What does a trustee do when an irrevocable trust needs to be modified? Circumstances or laws may have changed in ways that could not have been anticipated at the time the trust was drafted. In the past, a trustee who wanted to change some aspect of an irrevocable trust had few options, other than a court order to reform the trust which can be a costly and lengthy process. Now, many states have alleviated the necessity of court approval to modify trusts by permitting “decanting.” (For an example of such a statute, see our prior post, “How is an Illinois Trust Now Like a Fine Wine? It Can Be Decanted: A Summary of the New Illinois Decanting Statute”.)
Decanting is the term generally used to describe the distribution of trust property to another trust pursuant to the trustee’s discretionary authority to make distributions to, or for the benefit of, one or more beneficiaries. Decanting may be permitted by statute, by the terms of the original trust or by court-created law. Currently, Massachusetts has no specific decanting statute. However, in Morse v. Kraft, 466 Mass. 92 (2013), the Massachusetts Supreme Court authorized the trustee of the Kraft family trusts to decant the trust without the consent or approval of the court or any beneficiary. (more…)
Taxpayers/insureds are often surprised when they are taxed on the value of an old policy that was underwater, when it was transferred to them, causing them to assume that the policy had no value for the government to tax. Here again, the taxpayers in Schwab v. Commissioner (9th Cir. 2013), were surprised that they had recognized taxable income on the distribution to them of life insurance policies from their non-qualified plan, which had surrender charges that exceed their cash value.
Michael and Kathryn, a married couple, were employees of Angels and Cowboys, Inc., which sponsored a non-qualified multi-employer welfare benefit plan that was administered by a third party. Each of them caused the plan to purchase, with a single premium, a variable universal life insurance policy with a three-year no lapse guarantee. Just prior to the end of the three year no lapse period, due to a change in requirements for such an employee benefit plan, the plan terminated and the life insurance policies were distributed to Michael and Kathryn. However, the policies were both subject to substantial surrender charges at the time of the distribution that exceeded the policy cash value, so that nothing would be paid to either of them on a cancellation or lapse of the policy. At the time of the distribution, Michael’s policy would lapse in 54 days and Kathryn’s policy would lapse in 24 days unless each continued to pay the premiums due on the policies. $108,031 in premiums would need to be paid on Kathryn’s policy to keep it from lapsing, so she elected to let it lapse, and received nothing on the policy. Michael elected to pay premiums on his policy for a time to keep it in force. (more…)